Special Finance®

Singing the Big Apple Blues

"So let me get this straight,” says the guy across the table from me, the guy wearing the $230 tie and the Ferragamo bifocals. “You’re giving a 72-month loan for 25 grand, secured by a vehicle worth 19 at best, to someone with a 540 FICO and $4,000-a-month income?”

Tie Guy manages part of the investment portfolio of a large insurance company. Out the window behind him and 42 stories down is Lower Manhattan, and at his fingertips are about $15 billion in investible funds. My boss and I are in town to try to get $40 million of that.

Tie Guy has been investing in subprime auto asset-backed securities for many years and has gobs of these bonds under his crocskin belt. But he asks the question rhetorically, to remind us that he’s the one with the money, which, naturally, makes him the one in control.

How times have changed

As recently as 18 months ago, a conversation like this would have been unlikely. Back then, investors lined up to buy auto-backed bonds, which provided relatively reliable and favorable returns, thanks in large part to the fact that repayment was in effect guaranteed by specialized companies called monoline insurers.

Back then, the process went something like this: The bond issuer — that’s the auto finance company that’s trying to raise operating funds by issuing bonds against future revenue generated by its obligors’ installment payments, similar to the government raising funds by issuing bonds against future tax revenue — would decide that it was time to “securitize” a portion of its portfolio. So it would hire an investment banker to manage the transaction and sell the bonds.

The investment banker would enlist a monoline to provide the bond insurance, and the monoline would work at arm’s length with the rating agencies (Standard & Poor’s, Moody’s, Fitch Ratings) to determine under what conditions the bonds would be able to enjoy the benefit of the monoline’s triple-A credit rating. This top-level credit rating was critical to make the bonds eligible for the portfolios of most of the big institutional investors.

Once these conditions were in place and the bond issuer, the investment banker, the monoline, the rating agencies and — of course — everybody’s attorneys had agreed on all the details, the deal would formally go to market. The investment banker would contact potential investors, discuss bond pricing and deal structure, emphasize the monoline’s triple-A rating, and maybe field a few innocuous questions about the bond issuer itself. Then the orders would come in.

Back then, an issuer’s sale of insured bonds totaling anywhere from a hundred million to a billion or more dollars would be completed within a matter of days, if not hours. And this whole process, repeated at regular intervals and to the tune of hundreds of billions of dollars over the past decade or so, was the lifeblood of indirect auto finance.

But a funny thing happened last year. You see, most of the big monolines hadn’t just insured auto-backed bonds. They’d insured all kinds of bonds, including those backed (cue the theme from “Jaws”) by subprime residential mortgages and a nifty form of finance voodoo called a collateralized debt obligation, or CDO.

The problem wasn’t that auto portfolios suddenly started to spiral out of control, because they didn’t. Deteriorating performance? Absolutely. But out of control? Not across the board. The main problem was that when things started getting shaky (not good) in subprime mortgages, CDOs and other bond segments, the rating agencies began to downgrade (not good) the monolines’ credit ratings to reflect actual and potential losses linked to the insurers’ commitments to back these bonds. Not all of the monolines were downgraded in one fell swoop, but enough of the big ones took a big enough hit (not good) to poison the punch for everyone. So in response, investors began to dump (not good) not only these bonds, but also their auto bonds at slasher-sale prices in an effort to reduce their portfolio exposure to the monolines’ increased risk.

Meanwhile, back in Gotham

Tie Guy knows that he can pick up one of my competitors’ existing bonds at a substantial discount. But he’s letting us tell him our whole story because he also knows that, outside of the rating agencies and the monolines, too few on Wall Street drilled down deep enough on the specific underwriting practices of the finance companies behind the bonds that are now in discounted circulation.

And Tie Guy’s having a great time. His interrogation darts from LTV to the Manheim Index to PTI to Term to SUVs to Net Interest Margin, back to LTV and Term, and from there to Term and LTV. (Did I mention that he’s obsessing over Term and LTV?) When Tie Guy checks a beep on his Blackberry, I give my boss a quick glance that says, “Damn, for someone who didn’t seem to care much a year ago, this guy really knows his stuff!”

Then Tie Guy gets medieval on us about the loans from 2006, when just about everyone in the industry — including us — booked a bunch of not-so-stellar paper. It’s the rack. It’s the iron maiden. It’s the Spanish Inquisition, every fun-filled step of the way.

But we catch him off guard when we tell him that our 2007 paper is actually performing better than the 2006 batch. He furrows his brow because this is the opposite of what he’s heard from nearly everyone else.

“In the fall of 2006, we started seeing some irregular performance activity,” my boss explains. “Delinquencies and early payment defaults were creeping up in a way that was unusual for us, given the economy and the composition of our portfolio. So we started dissecting.”

My boss details to Tie Guy how we identified what we believed to be the causes of these portfolio hiccups and, right around Halloween, made immediate and decisive changes to several underwriting fundamentals such as employment, income and our internal score card. Our dealer clients really struggled with the rationale behind these adjustments, especially because our competitors were going full steam ahead. Some of our dealers dropped us. Most stayed on board, but had to recalibrate to our changes. And as you can imagine, our origination volume took a big hit.

“But it’s because of those changes we made at the end of ’06, and changes that we’ve continued to make throughout ’07 and into ’08,” my boss concludes, “that we were able to maintain the integrity of the portfolio, buck the industry trend in losses, and be in a position to present this investment opportunity to you today.”

As Tie Guy examines the performance data we’ve placed in front of him, his skeptical scowl gives way to a hint of an approving nod. Even so, I know that this money — if we get it — is going to cost my company more than any funds we’ve raised in recent memory. But I remain hopeful because we’ve got a lot of dealers who rely on our finance products to sell quality vehicles to their growing segment of credit-challenged buyers.